15.2 Working capital ratios

Question 1

Working capital ratios

Answer 1

• A series of working capital ratios are used to determine the working capital cycle
• The ratios for the inventory, receivables and payables are normally expressed as the number of days/weeks/months of the relevant SPL figure they represent

Question 2

Calculating working capital cycle indicates

Answer 2

• how may days between paying for material purchases and receiving cash from customers
• this must be compared with prior periods or industry average for meaningful analysis of entity’s performance

Question 3

Calculation of working capital cycle - Manufacturing

Answer 3

Raw materials holding period / days
LESS: Payables payment period / days
PLUS: WIP holding period / days
PLUS: Finished goods holding period / days
PLUS: Receivables collection period / days

Question 4

Calculation of working capital cycle - Retail

Answer 4

Inventory holding period / days
LESS: Payables payment period / days
PLUS: Receivables collection period / days

Question 5

Inventory period ratios:

Answer 5

• Raw material inventory holding period - length of time raw materials are held between purchase and being used in production
• WIP holding period - the length of time goods spend in production
• Finished goods inventory holding period - length of time finished goods are held between purchase/completion and sale
• a low ratio is usually seen as a sign of good working capital management (it is expensive to hold inventory and therefore minimum inventory is usually good practice)

Question 6

Raw material inventory holding calculation

Answer 6

Average raw material inventory held / Material usage * 365

Average raw material inventory held = (Opening inventory + Closing inventory) / 2

• Where usage can’t be calculated purchases gives a good approximate

Question 7

WIP holding period calculation

Answer 7

Average WIP / Production cost X 365

• Where production cost cant be calculated cost of goods sold gives a good approximate

Question 8

Finished goods inventory holding period calculation

Answer 8

Average finished goods inventory held / Cost of goods sold X 365

Question 9

Trade receivables days is / calc

Answer 9

the length of time credit is extended to customers

Average receivables / Credit sales X 365

• Generally shorter credit periods are seen as financially prudent but length will also depend on nature of business

Question 10

Trade payable days is / calc

Answer 10

• the average period of credit extended by suppliers

Average payables / Credit purchases X 365

• Generally the longer the better as entity holds onto own cash

Question 11

Corresponding turnover ratio

Answer 11

can be calculated by inverting the ratio and removing the multiple

Question 12

Ratios have their limitations:

Answer 12

• the SFP values at a particular time may not be typical
• balances used for seasonal businesses may not be average levels
• ratios can be subject to manipulation
• ratios concern the past (historic) not the future
• figures may be distorted by inflation and/or rapid growth